Birgit Ennemoser (birgit.ennemoser@auren.de), managing director Personal Services
Everyone is still talking about “remote work” or “workation”. The associated risks have also been raised again and again. The greatest risk is likely to lie in the creation of a permanent establishment. Companies should review whether the permanent establishment risk (PE risk) can be minimised for employees who no longer work exclusively in their employer’s country of residence.
A foreign permanent establishment does not necessarily result in an additional effective tax burden. This is because double taxation agreements (“DTAs”) and national rules on the crediting of foreign taxes often only lead to a distribution of taxation. In German treaty practice, double taxation of corporate profits within the meaning of Article 7 of the OECD Model Tax Convention (“OECD-MA”) is generally avoided using the exemption method set forth in Article 23A OECD-MA. If lower tax rates apply abroad than in Germany, the effective tax burden could therefore even be reduced if the foreign permanent establishment results are exempted from the German tax base.
However, a foreign permanent establishment entails an administrative burden that should not be underestimated. Compliance obligations abroad include, for example, registering for tax purposes, submitting local tax returns and tax registrations in accordance with the applicable deadlines and complying with local accounting and determination of income rules.
Determining the profits of a permanent establishment is a complex and challenging task from an income tax perspective, but the consequences from a VAT, payroll tax, social security and employment law perspective must also be taken into account.
In addition to legal compliance requirements, non-tax-related issues often constitute in practice a significant part of the administrative burden associated with a foreign permanent establishment, e.g. in connection with opening local bank accounts, the use of electronic portals for communication with the authorities, regulations on the preparation and disclosure of annual financial statements and language and cultural barriers in communication with the competent authorities.
It is particularly risky where foreign permanent establishments are established inadvertently or unnoticed and the consequences are only recognised after the fact, which can result in substantial fines being imposed on and in criminal consequences for the management and persons involved.
In order to clarify the question of whether or when the activities of employees create permanent establishments, the respective national law and the provisions of the respective DTA must be reviewed. As neither the national provisions nor the provisions in the DTAs are identical, a review on a case-by-case basis needs to be carried out. The complexity of the task is further increased because a permanent establishment for income tax purposes does not necessarily guarantee that a permanent establishment also exists for VAT or payroll tax purposes.
A foreign place of business set up to carry out business activities with a degree of permanence regarding their duration and geographical location is the classic form of a permanent establishment as a fixed place of business. The unwritten requirement that the domestic company has the power of disposal over the foreign place of business plays an important role.
The use of the business equipment does not have to be extensive or particularly important for the company. Subordinate operational processes can also lead to the existence of a fixed place of business. The presence of a storage area, a vending machine or a locker may therefore already meet the requirements for a fixed place of business.
However, a fixed place of business can only lead to a permanent establishment if the taxpayer exercises more than just a temporary power of disposal over the place of business. They must therefore be able to actually use the place of business. Therefore, a company can also maintain a fixed place of business at the premises of a third-party company if, for example, this third-party company is contractually obliged to provide the taxpayer with a workplace.
Under German law the employer does not regularly have the power of disposal over the premises used by the employee in the case of “remote working” or working from home.
However, the definition of a fixed place of business as a permanent establishment may differ from the German view under foreign law or the respective interpretation of the DTA, in particular with regard to the question of the employer’s power of disposal over the employee’s home office.
A place of management requires that at least part of the company is managed at this location and that the majority of the relevant decisions are made from there. This means that important company decisions (relevant to the day-to-day business) are made from abroad, for example when one of the managing directors is abroad for a longer period of time.
According to a controversial opinion, this does not necessarily require a fixed place of business or the company’s power of disposal over the premises used – which is often the subject of debate in practice.
Relief provided by the OECD to companies during the pandemic-related lockdown, which was intended to prevent the forced and serial “emergence” of permanent establishments as a result of the mobility restrictions then in force, are not transferable to permanent mobile working solutions.
An agency permanent establishment is established if an employee is deemed to be a permanent agent of the domestic company for tax purposes. A permanent agent is a person (can also be a corporate body) who works for the company on a long-term basis (in particular in connection with the negotiation and conclusion of contracts) and has a certain dependency on the company.
Until the revision of Article 5 (5) OECD-MA in 2017, the agent had to have a power of attorney for the company represented according to the wording of the model convention. In this context, it is questionable whether, according to the wording, it is only the formal legal conclusion of the contracts by the agent from a civil law perspective that is important, or whether the specific involvement and final negotiations in concluding the contract should also be taken into account from a commercial perspective. Although this has been appropriately clarified in some DTAs and in Article 5 No. 32.1 of the 2017 model commentary that the term “power of attorney” is to be interpreted according to its economic content, it is advisable to review this interpretation in individual cases on the basis of the applicable foreign tax law.
In the new version of Article 5 (5) OECD-MA in 2017, the requirement of a power of attorney was removed and the concept of the agency permanent establishment was extended so that commission transactions can also result in the creation of an agency permanent establishment, i.e. if the agent sells the goods as a commission agent in his own name but for the account of the principal resident in the other country. This is likely to play a particularly important role for DTAs from 2017 onwards.
We would like to point out with regard to the application of the Multilateral Instrument (MLI) that Germany has not accepted the relevant amendment of Article 5 OECD-MA for any of its DTAs.
The definition of a so-called service permanent establishment can only be found in a few agreements to date, e.g. in the DTA between Germany and China. Accordingly, the provision of services abroad over a certain period of time (i.e. exceeding the 183-day limit) is sufficient to trigger taxation analogous to a permanent establishment. In contrast, this form of permanent establishment does not exist from a German perspective because, among other things, the taxpayer does not have the power of disposal.
Some taxpayers have shifted their foreign business activities entirely to the home office. Rental agreements for permanent office space abroad were terminated or property owned abroad was sold. It is questionable whether this constitutes a foreign home office permanent establishment in the sense of a fixed place of business. According to the OECD, foreign business activities carried out from home should not automatically lead to the employer gaining control over the home office of the employee resident abroad.
However, if the home office is used regularly and permanently (for more than six months) and if it is clear from the facts and circumstances that the domestic company requires the employee to perform his/her work in the home office, a foreign home office may be deemed to be a permanent establishment of the taxpayer.
However, under German tax law, home office activities should not in principle constitute a permanent establishment because, according to the established case law of the Federal Finance Court (Bundesfinanzhof), the requirement of a power of disposal is generally not met in the case of a home office permanent establishment. Even if the employee’s home office is set up by the employer or the employer pays the pro rata rent, the power of disposal over the home office remains with the employee.
The tax assessment depends on the facts and circumstances of the individual case. This should also be reviewed on the basis of the respective foreign tax law and the applicable DTA.
Another approach to reducing the PE risk is to restrict employee activities abroad to activities of a preparatory nature or auxiliary activities within the meaning of Article 4 (4) OECD-MA. In addition to applying the OECD’s definition of a home office, this measure would ensure that no “harmful” agency or management activities are carried out from the home office, which may result in the creation of permanent establishments for income tax purposes even if there is no fixed place of business.
However, the feasibility of this measure essentially depends on the job profile of the employees and the company’s business. As examples of preparatory and auxiliary activities, the OECD Model Commentary mentions the operation of social facilities and business premises used exclusively for advertising, the provision of information, scientific research or the management of a patent or a know-how contract. However, this activity may only be carried out within and for the benefit of the company, may not constitute a commercial activity vis-à-vis third parties and may not accord with the company’s main activity.
In many cases, the PE risk can be permanently reduced by restricting the activities carried out abroad to preparatory and auxiliary activities. However, in addition to the formulation of corresponding guidelines, this measure also requires the procedural implementation and monitoring of employee activities. The latter may not be desirable in practice from a business perspective. The cost of implementation must therefore be carefully assessed.
Another approach is to employ the employee at an existing foreign Group company. As a rule, this does not result in a permanent establishment of the domestic company, provided that it is ensured that the foreign group company is not only to be regarded as the employee’s employer under civil law, but also as the economic employer, and that it is not a case of personnel leasing. The foreign group company must de facto exercise its duty of care as an employer towards the employee and remain authorised to issue instructions. In this case, the service or activity required by the domestic company is no longer owed by the employee, but is regularly purchased by the foreign group company as part of a service or framework agreement.
The correct implementation of this measure can result in a permanent reduction or complete avoidance of the foreign PE risk, even in the case of long-term stays abroad. However, there are often obstacles in resolving the organisational integration of the employee into his or her previous company, because this is always accompanied by a change in the employee’s disciplinary line manager.
However, when it comes to providing distribution services for the domestic company this measure is only suitable to a limited extent . In these cases, there is an increased risk that the sales activity will lead to the creation of an agency PE abroad. Companies should check the tax perspective of the foreign tax authorities and, if necessary, restrict and document the scope of the sales activities. However, if arm’s length remuneration is already ensured at the foreign group company, additional earnings would not have to be allocated to such an agency permanent establishment (so-called zero-sum theory).
This is also a frequently chosen approach. As freelancers are generally not considered employees of the company or are not directly subject to its instructions, their activities do not constitute a permanent establishment of the company. An essential requirement is that the freelancer is effectively independent. It is also advisable to keep the freelancer’s activities on a short-term basis, e.g. on a project-related basis. Furthermore, the freelancer should not be economically nor organisationally integrated into the domestic company. The performance risk arising from the services provided should lie with the freelancer and not be borne by the company.
The potential for mitigating risk by using local freelancers is rather suitable for short-term stays of less than six months. As the duration of the cooperation increases, a review should be carried out at regular intervals to determine whether there is a risk of pseudo self-employment. An increased PE risk exists in particular if the freelancer is employed as an employee of the company before or after becoming self-employed.
An “employer of record” is a third-party company abroad that hires individual employees locally (as an employer under civil law) abroad for a fee and then “lends” them back to the domestic company. However, since such employees are generally still integrated into the domestic company in organisational terms, the latter regularly remains the economic employer. In our opinion, the “employer of record” approach is only suitable for effectively protecting the company from a foreign permanent establishment risk in a few cases.
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